12/05/2006 @ 10:00AM

Rent Your Stocks

Profit-oriented real estate investors would never leave their vacant properties idle and not use them to generate income. Investors will rent or lease these properties to create a steady cash flow. Did you know that you could do this with your existing stock positions?

Consider all the stocks you own, or are planning to own. While you take ownership in these stocks believing they will increase in value, not all stocks move as quickly or in the amounts you would like them to. This is when an investor can use these shares that are experiencing slow or stalled growth to generate additional returns with covered calls. As we discuss this strategy, here are a few steps we will cover:

A covered call is a way to use call options as a method of leasing your stock position. An investor simply sells a call option against his or her existing shares of stock. The term “covered” means you own shares of the stock to cover the call option you are selling. A call option is a contract that gives the buyer the right to buy 100 shares of the underlying stock from the seller, and obligates the seller to sell 100 shares of stock to the buyer. By selling this option, you are entering into an agreement to sell your stock, so make sure this is stock you would be willing to sell.

To take advantage of this strategy, look at the available options on your stock. Let’s assume you hold a position in
Microsoft
. The company has experienced nice growth during the last five months. However, let’s assume that MSFT might start to slow down and hover for awhile. Since you do not want to close your position and you still want to use this stock to create as much profit as you can, you will look at the listed call options to consider the covered call strategy.

Since MSFT is trading around $29 per share, let’s say you sell a January $30 call option contract. The buyer of this contract pays you a premium of $0.55 per share and has the right to buy this stock from you at $30 per share through the third Friday of January 2007. Under this contract, you are obligated to sell your 100 shares of MSFT if the buyer decides to exercise his or her right to buy the stock.

Imagine that MSFT is trading at $32 at expiration. The buyer of your option has the right to purchase the stock from you at $30. With the current market price at $32, if the buyer bought your shares at $30 and sold them back to the market at $32, the buyer would yield a $2-per-share profit on the stock. Once the $0.55-per-share premium is subtracted from the gain, the buyer makes a $1.45 profit on this trade.

Let’s look at this trade from your perspective. If you purchased the stock at $29 per share, and then you fulfilled your call obligation to sell the stock for $30, you would have made a $1-per-share profit. But wait: The option buyer also paid you a $0.55-per-share premium to buy the call. Therefore, you make a total return of $1.55 per share.

What if MSFT remains at its current price at expiration? If the price per share at expiration is $29, the buyer of this contract would have no incentive to exercise the option and buy the stock from you. There is no reason to pay $30 for a stock when it is trading at $29 per share. The option would expire, worthless and the premium you collected is yours to keep. So, if you had paid $29 for the MSFT shares and the price has not moved, you would still have made $0.55 per share on this trade.

Another added benefit to this strategy is your downside protection. The premium you receive in this trade brings your cost basis for the trade down–meaning you can weather some price movement to the downside without losing ground in the trade. Going back to the example, if your original cost basis is $29 and you are paid a $0.55 premium, your new cost basis, or breakeven point, drops to $28.45. If MSFT pulls back to $28, your $0.55 premium cushions your loss in the stock price.

Here are a few key points to remember:

–Aim for selling calls from month to month when appropriate. This will bring cash into your account every month.

–Make sure you don’t limit your upside. If you expect the stock to move increasingly higher, a covered call will only allow you to profit up to the strike price you are selling. Covered calls aren’t appropriate for all stocks.

–Don’t use this strategy on stocks you aren’t willing to sell.

–Don’t use this strategy to rationalize holding onto a bad stock. If you see the stock moving below your breakeven point, research the condition of the company to ensure it is worth owning.

The covered call strategy is a conservative, income-producing strategy. Start analyzing your current stock trades and see how covered calls would supplement your investment approach today.